4/29/2010 @ 5:15PM59 views

Swaps Split Could Cost Banks $85 Billion In Capital

The debate on financial reform moved to the Senate floor Thursday, as the financial industry warned of potentially dire and costly consequences of some of the proposals.

Wall Street’s biggest worry is a provision in the Senate Agriculture committee’s derivatives bill that would bar swaps dealers from accessing the Federal Reserve’s discount lending window or any other government guarantees. Swaps are derivative trades used by banks, financial companies and commercial companies to offset risks or bet on certain outcomes. The biggest U.S. banks are the biggest dealers, controlling 96% of the swaps market. The bill would force them to spin off or divest their swaps desks and create new entities for those activities. To do that, according to JPMorgan Chase analyst Kian Abouhossein, banks would have to come up with $85 billion in capital.

On Wall Street it’s being portrayed as a sneaky way to bring back the Glass-Steagall Act, the Depression-era law that separated the riskier trading and securities activities of investment banks from federally insured, and implicitly guaranteed, commercial banks. The banking industry spent 60 years chipping away at Glass-Steagall and finally got it repealed in 1999.

If you believe the swaps dealers, the proposal to split swaps from commercial banking is going to have disastrous consequences. “Based on our analysis, derivative trading liquidity would become very expensive,” London-based Abouhossein wrote in a note Thursday. He adds the new swaps entities, unable to use their balance sheets to attract business, would most likely not survive.

Having the certainty of discount window access is exactly why the biggest commercial banks are the biggest swaps dealers. They are too big to fail, making them the perfect counter parties.

The senators want to end too big to fail, however. Reuters notes more than 100 amendments are floating around in the Senate, and some of them address this issue. An earlier provision in the overall bill, introduced by Senate Banking Committee Chairman Christopher Dodd (D-Conn.) would have forced banks to fund a $50 billion pool to be used in the future to unwind a failing major bank, so taxpayer money didn’t have to be used. But the fund was seen as another way to signal that a limited group of companies are too big to fail. It isn’t expected to survive the vetting process.

The swaps proposal might not survive either–it’s seen as a possible bargaining chip for other contentious issues, like the structure and scope of a consumer protection watchdog.

Swaps are a lucrative business for Wall Street. Abouhossein estimates global investment banks will generate $117 billion in revenues from their fixed income divisions this year, more than half (about $65 billion) coming from derivatives. In terms of profits, derivatives are even more important, he says, making up two-thirds of the fixed income world’s bottom line.

Abouhossein sees regulation cutting into bank profitability overall, with return on equity, a measure of profitability, falling to 12% from 19% for big banks. Chief executives will be forced to look for ways to cut costs to come up with ROEs that are more acceptable to investors. Compensation is a likely target, he says. That would make Washington and the public happy. Wall Street? Not so much.

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